When the pension asset allocation changes which of the following is least likely to occur? A) The equity beta will change while the total value of firm assets remains constant. B) The higher the investment in bonds in the pension assets the more debt the firm will need to issue to maintain the same overall level of risk in the firm’s capital structure. C) The total value of liabilities and equity stays the same even though the amount of equity capital changes.
A?
C? by elimination…
Keep 'em coming : )
C…haven’t looked at this in a while…but hoping that’s right…!
C?
B I think…
C?
I would say B …
C
Without further adieu… Your answer: C was incorrect. The correct answer was A) The equity beta will change while the total value of firm assets remains constant. The firm’s equity beta remains the same as the asset allocation in the pension assets changes but the total asset beta, equity capital, debt financing, and debt-to-equity ratio will all change. As the percentage of pension assets invested in equities increases the total asset beta will increase and to maintain the same equity beta the level of risk in the firm’s capital structure must decrease, thus the firm must issue more equity and reduce the amount of debt financing hence the debt-to-equity ratio will decrease. This makes no sense to me. Someone care to explain?
dammit…misread the question… 1. Firms normally over estimate their WACC 2. When including the pension asset allocation - this changes the overall asset beta of the firms’ assets. A is correct because When the pension assets allocation changes i.e higher equity for example - this increases the total pension asset beta -->When this is combined with the firm’s asset beta - it produces a higher total asset beta (weighted average of firm asset beta and plan asset beta --> which in turn increases the firm’s WACC --> To bring the WACC back DOWN to its original level --> the firm would need to reduce it’s debt (or debt/equity) ratio --> because this in turn will decrease the firm’s equity beta --> and reduce the overall WACC of the firm. (They do this by issuing equity and retiring debt) B is incorrect because The higher the portion of bonds in the pension assets —> the lower the pension asset’s equity --> the lower the pension assets beta --> when combined with firm’s asset beta --> lower weighted average beta --> need to increase beta --> need to increase debt in firm --> increase equity beta --> increase overall beta = Hence this statement is true and NOT least likely to occur C is incorrect because (and this is what i read wrong) Whether increasing or decreasing debt the counter adjustement is made in equity --> Therefore the TOTAL (sum of) liabilities and equity stays the same - even though the amount of equity changes = Hence this statement is true and NOT least likely to occur hope there are no typos…!
Hmm Looks like i really need to review this material
great explanation mumukada… anyone know what study session this was?
Institutional investors- session 5 I believe.